Why instability isn't toppling world markets

Months of turmoil hold lessons for how to keep one 'domino' fromfelling whole system.

January 21, 1999

By James L. TysonStaff writer of The Christian Science Monitor

WASHINGTON

Eighteen months after turmoil in Thailand toppled financial markets worldwide, several factors are preventing market chaos in Brazil from triggering another destructive chain reaction - at least for now.

Recent trends in finance suggest that investors, and maybe even officials, are learning better how to deter a domino fall of markets - by tactics that range from lending money more cautiously, to cutting interest rates in an effort to restore liquidity to cash-strapped markets.

So, rather than expect markets to crash, the world should prepare for them to sway severely for years, many economists say. Meanwhile, the industrialized countries are trying, with mixed success, to update the global financial system to minimize future market swings.

One key has been US commercial banks' decision to slash lending to Brazil by 25 percent between June and September, according to the US Federal Reserve. Hedge funds and investment banks are also reducing risk by borrowing less to bet on capital markets.

Moreover, Brazil has apparently learned from the bungling of other nations during 1-1/2 years of financial turmoil. Officials there freely floated the Brazilian currency, the real, rather than burn up billions of dollars of government reserves in a vain defense against speculators.

Finally, if investors and foreign officials stumble, the US Federal Reserve has proved willing to cut interest rates and to flood markets with liquidity to restore stability. Three-quarter-point interest-rate cuts by the Fed last fall helped prompt copycat moves by more than 50 central banks worldwide. Markets rebounded.

Still, economists see many reasons turmoil could continue - and perhaps even worsen.

"There will be recurring crises that will keep us focused on the need to do something" on the global level to restore calm, says David Hale, chief economist at Zurich Kemper Investments in Chicago.

Indeed, the economies of many countries not already in recession are slowing, including those of Britain and Germany. Pakistan and Ukraine are straining under foreign debt at a time of little or no economic growth. Russia still has not resolved its August debt default. And in Brazil, the potential exists for new problems to emerge under a freely traded real.

Many economists can even envision another credit crunch like the one that emerged in September - and then faded.

Japan, meanwhile, remains in recession, despite efforts to bail out its debt-ridden banks and stimulate the economy. A stronger yen will harm Japanese exporters. Moreover, it will prompt more Japanese to buy foreign goods, perhaps causing layoffs or job losses in Japan.

China, its economic growth falling and joblessness rising, is rubbing up hard against its pledge not to devalue its currency as a way to aid exporters. Such a devaluation would especially jar other troubled East Asian economies.

In the United States, robust growth, low inflation, and almost-full employment hide big weaknesses: a negative personal savings rate, high foreign borrowing, and what many say is an overvalued stock market.

Moreover, any additional interest-rate cuts by the Fed - although acting as a tonic to flagging foreign markets - could backfire here at home: Easier credit could fan red-hot consumer spending and pump up the stock market to the point of an explosive correction.

Markets for the 21st century

Finally, US efforts to build a "new financial architecture" for world markets are moving ahead - but not fast enough to halt instability from spreading to weak or poorly regulated economies.

So far, the US and other major industrialized countries have started constructing a short-term line of credit that some troubled countries could use to scare off speculators. Such thinking was behind a $41.5 billion International Monetary Fund (IMF) package for Brazil.

They've also agreed to make international finance more open, thereby clarifying the risks for investors. They hope to hammer out a consensus on standards for government regulation and investment, and bolster incentives for following such rules.

Washington also aims to improve surveillance of capital markets and reform the much-maligned IMF, including making it more sensitive to the social problems caused by the strings attached to its aid.

Although orchestrating a broad consensus, Washington so far has not parlayed it into concrete reform.

But a US Treasury official, reemphasizing Washington's intent, says it "is very important that the international community works to develop codes for standards and best practices ... and give emerging market economies something to shoot for."

Sovereignty vs. global order

Ultimately, Washington confronts a classic tension in international affairs: It must reconcile nations' sense of sovereignty with the imperative for global order. Many countries will probably not eagerly yield power to an international effort at market regulation.

"We've built an international financial market without the infrastructure to support it," says Dani Rodrik, professor of international political economy at Harvard University in Cambridge, Mass. "Given the system of nation-states, it's hard to see how we can construct the financial framework at the global level that we badly need."

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